As the world economy continues to struggle, people are taking to the streets by the thousands to protest painful cuts in public spending designed to reduce government debt and deficits. This fiscal fury is understandable.

People want to regain the confidence they once had about the future when the economy was booming and more of us had jobs.

But after a protracted economic crisis, this will take planning, fair burden-sharing, and time itself.

If history is any guide, there is no silver bullet to debt reduction. Experience shows that it takes time to reduce government debt and deficits. Sustained efforts over many years will ultimately lead to success.

Most countries have made significant headway in rolling back fiscal deficits. By the end of next year in more than half of the world’s advanced economies, and about the same share of emerging markets, we expect deficits —adjusted for the economic cycle—to be at the same level or lower than before the global economic crisis hit in 2008.

But with a sluggish recovery, efforts at controlling debt stocks are taking longer to yield results, particularly in advanced economies. Gross public debt is nearing 80 percent of GDP on average for advanced economies—over 100 percent in several of them—and we do not expect it to stabilize before 2014-15.

So what can governments do to ease the pain and pave the way for successful debt reduction?

I would highlight two key premises that governments must meet for fiscal consolidation to succeed.

First, governments need to put together a credible medium-term plan and stick to it. This plan should be based on structural (not nominal) targets to allow flexibility in response to the economic cycle. Such plans are a vital ingredient when it comes to restoring confidence. For most countries, this means tackling the thorny issue of entitlement reform.

Second, governments need to ensure that fiscal adjustment is fair and carried out in a transparent manner. Spending cuts and tax raises that people perceive as unfair are unlikely to be sustainable.

Let me elaborate on both.

Restoring confidence

Adjustment to restore fiscal sustainability in high-debt countries will need to be gradual and steady. The pace of consolidation should reflect the size of adjustment needs, the state of the economy, and financing constraints. As a general rule, adjustment of about 1 percentage point of GDP per year seems an appropriate pace for advanced economies over the medium term.

Large advanced economies should take the lead in providing certainty. The United States should define a reasonable plan to reduce government debt and deficits to avoid the “fiscal cliff.”

Japan needs to proceed with a decisive debt reduction plan that includes both revenue and entitlement reform. The recently enacted consumption tax hike will slow debt accumulation, but not arrest it.

In the euro area, determined steps to implement a robust fiscal governance framework that limits moral hazard remains of the essence. A credible roadmap toward a banking union and fiscal integration will enhance necessary crisis actions.

Both advanced and emerging economies need to tackle entitlement reform. Pension and health spending is projected to increase by over 4 percentage points of GDP in advanced economies by 2030, and by 3 percentage points in emerging markets. Pension reforms have been widespread in the last few years, but health care reform has been more timid, and in many countries remains the key long-term challenge for public finances.

I personally worry most about getting health care spending under control—reforming health care in countries with rapidly aging populations is a complex undertaking. In contrast, pension reform, while politically difficult, is fairly straightforward—governments can address costs by increasing the retirement age and looking at contribution and benefit rates.

A fair plan

Income inequality tends to rise when governments need to cut debt and deficits, but this does not have to be the case. Countries should limit the painful social effects of debt reduction and build their plans to last. This means they need to tailor policies to support social equity and long-term employment.

In practical terms, this means a degree of progressivity in taxation and access to social benefits. An enhancement of social safety nets should be supported by greater means-testing and monitoring. Policymakers can improve equity by fighting tax evasion, and—particularly in low-income and emerging economies—subsidy reform.

In many advanced economies, including in the euro area, reviving long-term growth and boosting competitiveness will require tackling policies that have been on the books for years but don’t necessarily work for a modern economy.

Countries often also need to strengthen their fiscal institutions and governance to enhance the credibility of medium-term fiscal plans.

In it for the long haul

The results of the changes taking place now will take time to bear fruit.

This is a frustrating truth for all those people who don’t have the luxury of time. That’s why it is so important for governments to make the case for reforms and to be as transparent and open as possible about their impact on the different segments of the population.

Young people in particular need to be involved and their voices heard loud and clear.

They, after all, are the ones who will bear much of the burden of repaying the consequences of past financial excesses.

9 Responses

Restoring confidence — it is hard to convince Americans in the United States. With the election just a couple weeks away, there seems to be no hope with our economy. Usually when it is election year, the economy is booming, but not this election year. There are 47.8 million Americans on food stamps. Gas prices are sky rocketing and there are no employment opportunities. Restoring confidence is unreachable!

In relation to the issue of whether restoring confidence is possible, let’s be sure we have clarity in distinguishing between confidence and bravado. In the years before the Great Recession struck, there was a lot of bravado that was both perceived and claimed as confidence. Perhaps the silver lining of the current clouds is that we are learning to distinguish between bravado and genuine confidence.

It’s hard to disagree with most of the points in this post. But it involves lots of political “shoulds”. The trouble is that politicians understand the option value of waiting as well as anyone. For a politician, all the reforms and policy actions mentioned here require them to spend substantial political capital on largely irreversible political actions, and at a time of great political and economic uncertainty. So they put off action, hoping that circumstances will be better tomorrow.

Frankly, it is not surprising that they are not doing what they “should”. The problem is that their failure to act is creating uncertainty for everyone else — so firms do invest or hire workers, which in turn creates uncertainty that feeds back to politicians. In short, we are stuck in a Nash equilibrium in which firms and politicians are exercising the option of waiting.

The key question is how break the Nash equilibrium and get politicians to act in the public interest despite their own interest.

Torrens Hume, indeed but one way for politicians to start acting would be to understand better just how faulty current bank regulations are, and that it is just not a matter of some tweaking a Basel III into a Basel III.1.

That said I am not giving up on making the bank regulatory establishment understand and confess.

The whole world is worried about these two Ds (Debts and Deficits). Whatever can be the social upheavals, there seems to be no escape from fiscal consolidation — spend less and owe less. This rapidly aging population will have to be tolerated since so far nothing has been found congenial on Mars to transport these exhausted humans to that planet.

This article by Ms Shafik is quite comprehensive and gives practical guidelines for all the economies presently having this debt problem.

“They (youth), after all, are the ones who will bear much of the burden of repaying the consequences of past financial excesses.”

That is the current overwhelming assumption. But IF we are to make a significant advance in social equity (and thank you, Ms. Shafik, for using the word equity rather than the word equality), then the burden of repaying the consequences of past financial excesses will have to be at least partially paid by those who have indulged in collossal departures from earnest honesty into bravadoic and/or cynical pretence of which some very well known figures in global finance/politics/economics/business have been egregiously guilty. This is not a plea for an eye for an eye, because not only was Gandhi right in saying that an “eye for an eye and the entire world goes blind”, but the reality must now also be courageusly faced that logical positivism was quite in error when it first raised its gorgon head and infected what passes for ‘thinking’ so badly that people like Per Kurowski were too often arrogantly ignored.

So will someone now dare to tell us that there is any solution to this painful legacy from which we must continue courageously digging out from that does NOT include hunting down ‘those laughing cavaliers of finance and politics and economics and business’ and putting them securely behind bars for enough time to get some abject apologies and demonstrated shifts toward more conscienable behaviour — as the French would say, “pour encourager les autres”?

In September 2002, one month before I became an Executive Director at the World Bank for two years, I published an OpEd titled “The riskiness of country risk”. In it I was referring primarily to developing countries, but what happened affected primarily the developed countries because they have naturally a larger abundance of AAA rated borrowers. The current crisis resulted primarily from favoring too much what ex-ante was perceived as absolutely not risky, including of course “The Infallible Sovereigns”.

http://subprimeregulations.blogspot.com/2002/09/riskiness-of-country-risk.html
But, unfortunately, though I tried, and I really did try, there was nothing I could do. Everyone was too enamored with the concept of “more perceived risk-more capital, less perceived risk-less capital”. It sounded so logical and it promised so much, and, in a mutual admiration club environment, no one dared or wanted to question sufficiently what was being done.

Except for statements at the Executive Board, at the only chance I got to reach out to staff, a workshop on regulations, I gave the following comments, and thereafter, until this day, I have never ever been invited to speak on the issue again.

As you can understand, the first thing that needs to be done, is to design a workable plan out of the Basel Committee bank regulations, and the last thing we need is a Basel III based on the same faulty principles.

In the name of my one year old granddaughter, I might even yell “We want capital requirements for banks based on job creation for youth potential ratings.”